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The Fight For Survival

July 23, 2000

Business Week e.biz -- Special Report

The Fight for Survival

The easy money is gone. Investors are wary. Can dot-coms manage the crisis?

Just a few months ago, Pseudo.com was the model of Internet ambition. Fueled by pools of money from venture capitalists, the New York City Net-media company was cranking out enough original TV-like programming to fill 10 Net channels. It was like starting up 10 TV stations all at once. But on Friday, June 23, Chief Executive Officer David Bohrman assembled the company's employees in its Soho offices and explained that Pseudo needed to change course. To conserve cash, it would concentrate its resources on one combined channel, Pseudo Center, that would offer its most popular shows on hip- hop, games, and other topics. Sixty of the 240-member staff would lose their jobs. As employees gathered in the corridors, a few began to cry. "It's not unlike losing a family member," says Jeanne Meyer, a senior vice-president at Pseudo. "It's a physical grief."

Pseudo is hardly the only Internet company suffering from some sort of grief these days. The conditions at many Net companies across the country have turned desperate in recent months. Investors who were willing to pour billions into money-losing startups for the past two years have suddenly turned off the spigots. And any hopes that the drought is short-term are fading fast. Without access to easy cash, many startups are finding themselves fighting for survival.

Now, instead of hatching grandiose plans for Web domination, Internet executives are hunkering down, trying to figure out how to manage their way through what looks to be a protracted dry spell. They know the days of cheap dough are gone and it's time to cut costs. But how? Should they ditch costly marketing plans that could help attract new customers and generate revenues--or ax jobs? If they ax jobs, how do they boost the spirits of those crucial staffers who remain? And if they cut either one, how do they keep a startup's energy, the air of invincibility that lets a tiny band of people achieve great things?

And what about those business plans that seemed so clever a year ago? Should they stick with them and weather the fallout, hoping enough rivals get creamed first so that online buyers will have to come their way? Or is it time to rethink the original game plan, add businesses, or eke out new revenue streams, however small, from whatever business has been built? "It's like playing Who Wants to be a Millionaire? and having the host say, `I'm sorry, you don't get any lifelines. In fact, you have to get the next eight questions right in three seconds,"' says William A. Sahlman, professor of entrepreneurial and service management at the Harvard Business School. "The rules have changed."

And many Netrepreneurs are simply too young to know how to cope with such an abrupt reversal of fortune. For better or for worse, their first reaction has been to slash jobs. InsWeb, an online insurance agency, cut 40% of its workforce in June. Furniture.com Inc. whacked its staff by 41% last month. And smalloffice.com, which offers advice to small outfits, shaved its employee count by 24%. All told, about 60 Net companies have laid off 5,400 workers since December, according to outplacement firm Challenger, Gray & Christmas Inc.

It's not just the rank-and-file that are being shown the door. As Net startups flounder, financial backers are stepping in to remove founders who are either too young or too inexperienced to handle this buckle-down phase of the business. In May, KBkids.com directors fired Srikant Srinivasan, the 34-year-old who launched the online toy retailer in his basement four years earlier. After a dismal holiday season, when the site kept crashing, and a pulled initial public offering in the spring, Srinivasan got the boot along with 44 other employees. "We had some teething problems," he sighs.

As the carnage stacks up and fears mount, the Netrepreneurs who remain are turning a gimlet eye to expenses. Extravagant advertising blitzes and shipping costs have been first on the docket. KBkids slashed its $43 million ad budget to virtually nothing, while online record store EMusic.com is saving $15 million by gutting its marketing plans. Struggling Furniture.com has stopped free shipping. And even Urbanfetch, a delivery site known for going all-out for customers, has imposed a minimum order of $10 to eliminate money-losing orders. "We drew a line in the sand," says Urbanfetch CEO Ross Stevens. "You could probably wait around for these people to increase their orders. But we weren't confident that was going to happen in a reasonable period of time."

Are Stevens and other Web CEOs doing the right thing? Maybe, but management experts worry that the same kind of willy-nilly planning that got companies in these financial jams is being applied now in much dicier times. Net execs who indiscriminately slash marketing expenses run the risk of seeing their sales crater. For companies bent on thriving, not just surviving, they need to figure out creative ways to become more efficient as they cut costs. "Blindly cutting back expenses is just as inappropriate as spending crazily," says Rashi Glazer, professor of marketing at Berkeley's Haas School of Business. "A good strategy is worth betting on and continuing to invest in.""Wrong lesson." History is a worthy guide. Booms and busts are the hallmarks of any huge technological innovation. It's creative destruction at work. Each round of breakthroughs, from railroads to airplanes, has led to hypercompetitive commercialization where scores of companies were born. Later, consolidation and bankruptcies wrack new industries as stronger players buy the weak or drive them out of business. The appropriate business models seem obvious in retrospect, but they rarely are during the birth of an industry. The early days of radio witnessed the "Euphoria of 1923" as companies tried to figure out how to profit. A popular magazine even sponsored a contest asking readers to send in suggestions for radio business models. It wasn't until 1926 that ad-driven stations became the prevalent model in the U.S.

What's different this time is the speed with which the cycle is evolving. One key reason is that capital markets are far more efficient than they were three-quarters of a century ago. Dozens of companies can quickly raise the money necessary to flood a particular market--and slug it out for preeminence. And this time the technology isn't a physical product like a steam engine or vacuum tube. Rather, the currency of the Net revolution is digital bits. Online companies haven't gotten bogged down in time-consuming tasks like manufacturing or distributing goods, says Hal R. Varian, dean of the School of Information Management and Systems at the University of California at Berkeley.

Like past eras, there's little question the shakeout on the Net will get worse in the months ahead. Merrill Lynch & Co. analyst Henry Blodget estimates that 75% of all Net companies will be eliminated through bankruptcy or consolidation. And failures are piling up almost daily. One recent example was the July 6 closure of WorldSpy, a free Internet service provider. "Let's face it, most of these companies didn't have realistic business models," says Berkeley's Glazer. "They were started by people with cool ideas and no business sense."

Still, many experts believe that the Net offers a tantalizing opportunity to build businesses that couldn't have existed without this vast communications medium. The smart money certainly hasn't been scared off. Venture capitalists continue to fund promising startups, such as the free Net phone provider Dialpad.com Inc. (page 83). "There are many Old Economy retailers that wish the Net would just go away. They have a tendency to look at what's going on now and say, see it's going nowhere," says Austan Goolsbee, associate professor of economics at the University of Chicago. "That's the totally wrong lesson to take."

The right lesson? Learn from others' mistakes and persevere. Although KBkids.com retrenched in May, its majority shareholder, retailer Kay-Bee Toy & Hobby Shops Inc., still wants to build up the site. That despite the added problem that Consolidated Stores plans to sell all of KB Toys--including the KBkids unit--within 12 months. The company's stock has fallen by nearly one-half in the past year, in part because of losses at KBkids. "The bottom line is we haven't given up," says Michael J. Wagner, the new CEO of KBkids.com. "The rules have changed, and we're trying to change with them."

How are Net companies trying to change? To find out, Business Week surveyed top executives at two dozen companies that are wrestling with the new realities of the Web. What we found is that these managers are doing everything from implementing major strategic changes to trying to ease employee anxiety. Here's a look at their efforts so far."We're doing what a lot of companies are doing to survive, we're focusing, streamlining, and latching onto what makes us special and different," says Pseudos' Meyer. "We're not trying to be all things to all people."

With the heat on, it's crucial for Net execs to come up with creative ways of moving their businesses forward. The same Young Turks who brought us completely new ways of doing business--online exchanges, name-your-price airline tickets--now need to use that brainpower to find creative ways of getting more bang out of their existing bucks. How? It starts with looking at the Net in altogether different ways. Amazon.com Inc., for example, moved beyond selling books, CDs, lawn chairs, and Cuisinarts to become a Web landlord, pulling in $31 million a quarter.

Now the others have to follow suit with new ways of making money. Urbanfetch chief Stevens decided the company could pull in more dough by using its underutilized warehouses and couriers to deliver goods for other companies. Already the company has cut a deal with French megastore Sephora.com Inc. to deliver beauty products. It expects to follow with similar deals for other products, including flowers and home furnishings. Because there's little additional cost to the new business, the shift is pegged to substantially boost Urbanfetch's financial results. Each courier also is expected to handle 50% more orders per hour. That should help make the company's New York operations profitable next year, a year ahead of schedule.

Another component of these strategic changes is consolidation. Just as in past technology cycles, stronger players are acquiring the weak to both squash the competition and increase their own economies of scale. On June 26, the grocery delivery service Webvan Group Inc. cut a deal to buy rival HomeGrocer.com Inc. for about $1.2 billion. Webvan expects the move to save it about $230 million in costs. What's more, the acquisition will allow the company to be in 15 cities by the middle of next year, six months ahead of schedule. "It made business sense when we looked at where they were in their rollout, and the markets we could get into without spending our capital," says George T. Shaheen, Webvan's CEO. "Plus, we wouldn't have to spend money to compete against them.""Analysts have gone from saying, `Why aren't you spending more?' to `Where else can you cut?"' says Steve Grady, marketing vice-president at EMusic, an online retailer.

It used to be a badge of honor for dot-coms to lose money. Boo.com spent lavishly on hotel rooms at the trendy SoHo Grand Hotel in New York and for first-class plane tickets. If a customer service or warehousing project went over budget at kitchen appliance and recipe site Tavolo Inc., nobody cared. Kevin Applebaum, the company's CEO, knew he could raise more money.

Those free-spending days are over. Now, Net companies must look for more efficient ways to operate--and some are making substantial progress. LetsTalk.com Inc., a Net retailer of cell phones and service plans, decided to substantially reduce its spending on expensive billboard, radio, and TV ads. Instead, it does most of its marketing online and has cut its customer acquisition costs by 80%. Urbanfetch also seems to be getting more mileage for its money. It has cut its TV and print marketing by 70% and, so far, has seen no drop off in sales.

What's obvious now is that some Net companies have endured a staggering amount of waste. As much as 40% of all the merchandise that Furniture.com shipped was returned, according to Dave Barrus, the company's logistics director who left in January because he didn't think the startup's business model would work. Returns proved expensive because Furniture.com absorbed the cost of shipments both to and from the customer, a total of as much as $400 round trip. The company disputes that the return rate was ever 40%--it says its returns average 10% to 15%. Now Furniture.com has a $95 shipping fee that it hopes will help lower returns. KBkids, on the other hand, suffered because its Web inventory system didn't mesh well with its warehouses. "People would come to me and say, `We've lost 2,000 Pokmon cards. Can you trace them down?', or `Uh-oh, we lost a million dollars of inventory, can you find it?"' says Derek Price, a logistics engineer. Now, parent KB Toys is handling the Web site's inventory.

Perhaps the most crucial change is that Net companies are trying to make all managers more cost-conscious. For example, six months ago, when Tavolo didn't have to worry about balancing its budgets, only CEO Applebaum and the chief financial officer would look at daily reports on the company's projects. Now 22 Tavolo managers get spreadsheets each day to find out whether the company is meeting its financial goals. "This environment demands that you make very strict financial decisions," says Applebaum."Morale is a constant thing that you have to deal with," says David Liu, CEO of The Knot. "I try to express to people that we're doing everything we need to do. We have to hold tight."

Employee morale used to be a nonissue at Net companies: There was a euphoric belief that everyone was going to get rich in the next few months, or maybe, at most, a year. Eighteen-hour days? Employees would be well-rewarded. Now, workers aren't even sure they're going to have jobs in a month. So attracting the best and the brightest--and holding on to them--is becoming monumentally hard. Top execs are scrambling to do everything they can to keep workers--from offering massages and ice cream to personally assuring workers that their jobs are safe.

Consider Delly Tamer, the CEO of LetsTalk.com. The head of the 40-person, San Francisco company has always had an open door policy, but earlier this year he started realizing that wasn't enough. In April, he began holding lunches with four or five employees at a local deli every Wednesday. They inundate him with questions: "You keep telling us we have good margins, are they good enough?" Or, "Will we have layoffs?" So far, the extra effort has helped Tamer avoid any turnover problems. Even better, employees have made nifty suggestions about marketing and improving customer services. "These people are smart," says Tamer. "We need to be open with them."

About everything. Beatnik Inc., which makes software to play music online, tried to prepare employees for changes and cutbacks by talking openly about its plans. In May, a dozen managers met at CEO Lorraine Hariton's house in Los Altos, Calif., to map out how the company would shift from putting audio software in consumers hands to licensing it to the makers of Net devices and mobile phones. The managers returned to their own teams and explained the strategy. Then the company held an all-hands meeting. Immediately afterward, 20 employees were laid off. "Before they heard about the meeting, everyone knew what it meant for them," says Hariton.

Beatnik is just one of many companies that are taking extraordinary steps to soothe employee angst. After online pharmacy PlanetRX cut jobs in June, John McAlpin, a senior vice-president who runs the company's distribution center, ended one shift early and called everybody together to make sure they knew their positions were secure. "Some joker who said they were all going to lose their jobs didn't know what he was talking about," McAlpin says. The CEO of Garden.com went so far as to send an e-mail while he was on the road to reassure employees that nothing worrisome was happening.

Some companies are taking steps to boost post-layoff morale that may seem, well, odd. After firing 35 people and consolidating operations into one office in San Francisco, ThirdAge Media Inc., a site for the over-55 set, held ice cream socials and offered massages for the 105 remaining employees. "We want to reinforce the idea with people that we're here to stay," says James Barnett, ThirdAge's CEO.

As Net execs manage their way through the current crisis, it's crucial they realize how important their decisions are. While great technology and good business ideas help a company, it's ultimately the execs who determine whether an enterprise makes it or not. In 1877, Thomas Edison invented the phonograph and later developed the most advanced version of the technology. But he made narrow-minded mistakes about mass production and recording artists that allowed rivals to beat him. Now, the competition, which became RCA, is an industry icon, while the Edison Speaking Phonograph Company is just a footnote in history. For Net execs, the stakes are clear: Icon or footnote?By Heather Green; Contributing: Dennis K. Berman, Rochelle Sharpe, and Jeanette BrownReturn to top